IR35 and the Law of Unintended Consequences

Have you ever wondered why there has been such a huge rise in the number of people using tax avoidance schemes in recent years?

Well, a lot of this is directly attributable to the introduction
of
IR35 back in 2001.

In the past, tax planning was mainly the preserve of the rich
and famous. However, more recently a plethora of schemes have been
marketed at self-employed contractors (also known as freelancers).
The individual sums involved are smaller but because they have been
used on a much wider scale, the loss to the Exchequer is
considerable.

There must be in the region of several hundred thousand
contractors in this country, so this poses a very serious
problem.

Background to IR35

The IR35 legislation was targeted at self-employed contractors,
many of whom work in the IT and Telecoms industry. Prior to IR35,
most contractors set up a limited company, paid themselves a small
salary, and received the rest of their income as dividends. Not
only is the tax treatment of dividends advantageous but also this
arrangement significantly reduces Employers NI contributions.

Contractors are required by agencies and clients to operate
through a Limited Liability Company, so they cannot benefit from
the lower rates of national insurance enjoyed by sole traders.

Before IR35, a contractor could have expected to net about 75%
of their gross income. Under IR35 they would be subject to PAYE and
full Employers NIC, and their net income could have dropped to as
low as 55%.

Self-employed contractors are, by nature, risk takers. It goes
with the territory. They surrender the safety net of job security
and employment benefits in return for a higher remuneration. They
also have to be extremely resourceful to compete in what is a
fiercely competitive market.

If a Government introduces legislation to attack their income
then it should come as no surprise that a majority will seek out
any means within the law to get around it.

Business as usual

Despite the introduction of
IR35, many contractors have continued to operate their limited
companies as though it simply never happened. A whole
industry has sprung up to help contractors draft contracts in such
a way that their working practices fall outside the scope of the
legislation. Many of these companies (eg. Qdos Consulting) also
offer insurance products to cover the legal costs of any
investigation by HMRC. However, even now there is still a lot of
uncertainty around IR35, and as a result large numbers of
contractors have turned to tax avoidance schemes instead.

Tax avoidance schemes

The tax avoidance industry were very quick to seize on the
opportunity handed to them by IR35. In recent years, we have seen
all manner of schemes emerging:

Managed Service Companies. The Government introduced
legislation in 2007 to put a stop to MSCs and Composite
companies

Double Taxation Agreements - Section 58 Finance Act 2008

Loans denominated in rapidly depreciating currencies

Employee Benefit Trusts

Offshore EBTs

Family Benefit Trusts

Foreign company dividends

Receiving income as a capital gain (exploiting the new lower
rate of CGT)

And the list goes on.

Many of these schemes have attracted thousands of users. Even
the introduction of the disclosure rules in 2004 has not curbed
their proliferation. Although some of the schemes provide the
contractor with a somewhat higher net income than running a limited
company, none of them would have been viable prior to IR35. Any
marginal benefit would simply not have compensated for the
additional risk.

Most of the schemes typically charge around 10% of the
contractor's gross income in fees. In other words, a large chunk of
money that would previously have gone to the Exchequer is now
lining the pockets of the tax avoidance promoters. This has allowed
these companies to accumulate huge war chests so they can hire the
best legal representation and vigorously fend off any challenges by
HMRC or Government.

Hidden Costs of IR35

The combined effect of many contractors changing their working
practices and the widespread use of tax avoidance schemes makes it
doubtful whether net tax receipts have benefited that much from
IR35. However, IR35 has also cost the taxpayer in other ways. HMRC
have expended considerable time and money trying to enforce it.
Despite undertaking many litigation proceedings, they have lost in
all but a handful of cases. In addition to this, there has also
been the relentless cost of investigating and plugging all the
various loopholes exploited by the tax avoidance industry.

Conclusion

IR35 has singularly failed in its intentions. A lot of
contractors have just modified their working practices and taken
out insurance products to protect themselves from investigation.
However, what should be of greater concern is that it has driven
many into the arms of the tax avoidance industry. The Government
has had to introduce raft after raft of legislation every year to
close down ever more ingenious schemes.

In response to the Arctic Systems case, the Government has
recently switched its attention to what it calls "income shifting".
A large number of contractors currently engage in this practice, so
if the Government brings in measures to curb this then it could
encourage yet more people to turn to artificial schemes.

Until something fundamentally changes, the tax avoidance
industry will continue to target the lucrative contractor market,
and the Government will be forever fighting a losing battle.